There are currently three primary types of computer accessible trading systems for securities such as stocks, bonds, commodities and derivatives. The first is the conventional stock exchange system exemplified by the New York Stock Exchange and New York Mercantile Exchange. On such exchanges the market is made for each security by a single registered stock dealer, such as a registered stock specialist, who has a seat on the exchange. In addition to face-to-face and telephone communication to the dealers/specialists on the floor, computers are used to send orders to the dealers/specialists on the exchange floor. Information as to the buy and sell prices (bid/offer prices, respectively) are supplied by the dealer/specialist to the exchange and brokers through the dealer/specialist's trading computer terminal. Electronic orders are matched by the dealer/specialist maintaining an orderly market. Upon matching an order the dealer/specialist confirms the execution with the trading terminal and a central computer which stores transaction data.
The second system is electronic exchanges which utilize electronic access of dealer posted market prices without a negotiating specialist or floor based exchange. The largest of these is NASDAQ. It is a totally computer-based market where each member dealer can make its own market in the stocks traded on the exchange through a computer network. Dealers trading a significant number of shares in a stock in their own name and profiting from the spread (i.e., the difference between the price which they purchase shares and the price for which they sell them) are called market makers. Market makers are most often, but not always, large financial institutions. There are usually a number of market makers in a stock, each bidding and offering stock for themselves or their customer.
The best bid to buy by any market maker and the best offer to sell by any market maker for a security is called the security's "inside market." NASDAQ supplies trading data to the participants via a computer network at three different service levels, known as Level I, Level II and Level III. Level I, inter alia, allows real-time access to the following data: (1) Inside market quotes (highest bid and lowest offer) for listed securities, (2) individual market maker quotations, as well as inside quotes for OTC Bulletin Board listed securities, (3) trade price and volume data. Level II additionally provides, among other things, real-time price quotations for each Market Maker and the inside price for each ATS in its computer network. Level III is a service limited to member dealers, allowing them to provide NASDAQ with their best bid and offer for securities in which they make markets, and receive incoming orders. There are various systems for displaying Level II and III data, such as disclosed in U.S. Pat. No. 5,297,032 to Trojan et al., issued Mar. 22, 1994.
Electronic exchanges may place, match, record and confirm transactions through their computer network. If a market order is placed through, for example NASDAQ without any restrictions, the NASDAQ computers make the actual match between an offer price and the bid price and thus will select the parties for the transaction. However a broker may indicate a preference to buy from or sell to a particular market maker.
Historically, market makers have solely determined the prices for securities on electronic exchanges such as NASDAQ. Non-members must place their orders and their customers' orders with a member dealer who receives a placement fee. Similar to other securities exchanges, electronic exchanges, such as NASDAQ, receive a fee for each such transaction.
The third trading system is alternative trading systems ("ATS") which provide ATS members and electronic exchange users, such as NASDAQ users, an electronic network by which they may display and execute their orders independent of a market maker or specialist. By doing so, members avoid conventional fees while enjoying more current and complete market information. ATSs are presently regulated under SEC Rule 17(a)(3) and 17(a)(4) as they apply to broker/dealer internal trading systems. Currently the most popular ATSs are ECNs. There are currently eight ECNs, including Instinet, Strike, and Island, with others under development and expected shortly. Given the recent surge in public electronic investment trading, demand for ATS access and the resulting traffic has increased sharply.
Each member of an ECN has a trading terminal that is connected with the ECN's central order book computer. Members display their bids and offers and conduct transactions through the resulting network. The ECN's order book computer keeps track of bid/offer information including price, volume, and execution for each open and closed transaction as supplied to it in real time by its members. The order book computer also records which computer, and thus, which member posted each bid or offer. Once a bid is hit or an offer is taken through the central order book computer, the central order book and members' trading terminals are so updated and the accepted bids and offers are no longer displayed.
ECNs were originally developed for their members to trade amongst themselves. Thus, each ECN developed its own terminals and protocols. The ECN receives a fee, normally based on transaction volume, for each transaction.
In a conventional stock exchange or an electronic exchange, buyers and sellers are subjected to intermediaries in the transaction, i.e., respectively the specialist or the market maker dealing in a particular security. However, in an ECN, each bid and offer is a discrete and anonymous order, fully viewable by and accessible to all its members. Accordingly a broker/dealer member or for that matter, simply a member, may have a number of bids and offers at different prices, posted on an ECN's central order book. There are no specialist or dealer intermediaries for these orders, thus removing third party delays and fees typically associated with traditional exchanges and electronic exchanges. The member controls through its trading computer all aspects of trading securities including order entry, price, volume, duration and cancellation. The member may, at its discretion, select desirable transactions from all open orders available as displayed from the ECN's central order book. The member may choose from the inside market for the security or at a worse price outside of the inside market. Such freedom is highly desirable. For example, it may be a wise strategy to buy securities at a price equal to or higher than the best offer in order to obtain more shares than the inside offer is displaying. This strategy also recognizes that the inside market is moving quickly and may not be available when trying to take the best offer.
Given the closed nature of individual ECNs, there are substantial fluctuations between the prices being offered within each ECN and between ECNs. In an attempt to solve the problem, SEC's Limit Order Rule requires each conforming ECN to display its inside market on electronic exchanges such as NASDAQ. The inside market data is displayed and accessed by users of the electronic exchange network. Such an ECN is a conforming ECN integrated with the exchange. An ECN will not receive NASDAQ quotes, but ECN members may receive this data if they are broker dealers.
Integrating ECNs and their inside market data with electronic exchanges only solves part of the existing market's fragmentation. A non-member of an integrated ECN only has access to the ECN's inside prices and may only execute upon them. Without membership in an ECN, i.e., a direct connection to the ECN, a user of an electronic exchange must use the electronic exchange as an intermediary to observe fluctuation in the ECN's inside market. Having to use an intermediary to an ECN will result in data transmission delays compared to members of the ECN who have direct access to the ECN's network. Finally when a trade is made by an ECN member through NASDAQ or a similar electronic exchange or by an electronic exchange user through the ECN, he/she usually pays two fees, one to the ECN and one to the electronic exchange.